Banks that avoided exotic lending such as subprime mortgages, structured investment vehicles (SIVs), and collateralized debenture obligations (CDOs), as well as lending in areas of
Banks cut dividends to preserve capital.
In comparison, during the 12-month period from October 1989 to October 1990, most bank stocks fell more sharply than recently, based on our calculations. Back then, as the
Strong growth in export industries, technology, agriculture, and healthcare, as well as actions taken by the Federal Reserve, plus fiscal stimulus plans, may be keeping the
- higher credit card debt to pay for monthly expenditures. Target and capital one had to write down nonperforming loans.
In the late 1980s, against a backdrop of concerns about banks credit quality, M&As became common, as strong banks took over weak or failing institutions. M&A activity accelerated in the 1990s before slowing in recent years. Consolidation may continue over the long term, as banks move to compete more efficiently in a less regulated environment.
Standard & Poors believes that long-term consolidation will continue to improve efficiency, boost sustainable profits, and help banks to withstand heated competition from other financial services providers, both domestic and international. If stock market conditions become relatively strong, we expect that more small- and medium-sized regional banks (those with assets of less than $20 billion) will continue to be absorbed by larger domestic or foreign banks.
As eligible merger partners dwindled in the late 1990s, acquisition trends changed. Notably, out-of-market deals became more frequent. In some large acquisitions, such as the 1998 deals between First Union Corp. (now Wachovia Corp.) and First Fidelity, and between BankAmerica and NationsBank Corp., banks bought into new geographic markets. A bank may adopt such a strategy if it cannot find a suitable intramarket merger partner, or if a certain geographic service territory is growing faster than its own.
BANK ASSETS
A commercial bank’s earnings are derived from a variety of sources. These sources, or “earning assets,” include loans (commercial, consumer, and real estate) and securities (investment and trading account).
Securities
Banks purchase securities as investments, with some 95% of their securities portfolios typically invested in fixed-income securities. A fixed-income security’s value depends on the interest rate it carries, and the security’s value fluctuates with the market level of interest rates. Securities may be taxable (such as US government bonds and other securities) or tax-exempt (such as state and local government securities). The maturities of these financial instruments vary widely.
Banks purchase securities as a means of earning interest on assets while maintaining the liquidity they need to meet deposit withdrawals or to satisfy sudden increases in loan demand. In addition, securities diversify a bank’s risk, improve the overall quality of its earning assets portfolio, and help the bank manage interest rate risk.
Investment securities are an important source of a bank’s earnings, particularly when lending is weak but funds for investing are plentiful. US banks are major participants in the bond market. Municipal bonds generally have longer terms and less liquidity than
Trading account securities are interest-bearing securities held primarily for realizing capital gains
BANK LIABILITIES
A bank’s principal liabilities consist of deposits, debt, and shareholders’ equity. Deposits include consumer demand and time deposits, corporate demand and time deposits, foreign deposits and borrowings, and negotiable certificates of deposit (jumbo CDs, usually sold in denominations of $100,000 or more). Debt includes federal funds and other short-term borrowings (such as commercial paper), as well as long-term debt.
When the economy is strong, businesses want to borrow to fund expansion. Similarly, when job markets are favorable and consumer confidence is up, demand for consumer credit increases. Conversely, economic slowdowns tend to reduce credit demand. In addition, shortfalls in corporate profits and personal income can hurt credit quality.
How to Analyze a Bank
When evaluating a bank, an analyst should consider both its profitability and its financial condition. Taken alone, short-term profit trends can be misleading. For example, if a bank achieves loan growth by engaging in excessively risky lending, it may be vulnerable to developments that would hurt its earnings or even threaten its survival over time.
It is important to note that the accounting systems of financial institutions are different from those of most other corporations. To judge a particular institution’s earnings and financial security, an analyst must use several measures. Such measures are most helpful when trends are examined over various periods and compared with data from similar banks.
Return on assets (ROA). A comprehensive measure of bank profitability is ROA — a bank’s net income divided by its average total assets during a given period. A trend of rising ROA is generally positive, provided it is not the result of excessive risk-taking.
· Because banks are highly leveraged, they tend to have low ROAs, relative to other industries. Historically, most banks have had ROAs within a range of 0.60% to 1.50%. Regional banks often have a higher-yielding loan portfolio; because of this, over the long term, they are more apt to have ROAs in the upper part of the range.
In 2007, the industry’s average ROA, annualized, was 0.86%, down from 1.28% in 2006, according to the Federal Deposit Insurance Corp. (FDIC).
- Return on equity (ROE). Another measure of profitability, usually considered in conjunction with ROA, is return on equity. A bank’s ROE is calculated by dividing net income by average shareholders’ equity.
Because shareholders’ equity normally backs only a small fraction (usually 5% to 10%) of a bank’s assets, ROE is much larger than ROA — typically, ranging from 10% to 25%. In 2007, the industry’s average ROE was 8.17%, compared with 12.34% a year earlier.
Banks that rely heavily on deposits and borrowings to support assets, rather than on stockholders’ equity, tend to have higher ROEs. An unusually high ROE versus ROA can indicate that the bank’s equity base is too small compared with its debt; this high leverage may limit its ability to borrow further.
- Yield on earning assets (YEA). Because banks can achieve a given profit level in a variety of ways, the components affecting net income must be considered when evaluating the quality of earnings. Interest-earning assets — loans, short-term money market investments, lease financings, and taxable and nontaxable investment securities — are the principal source of most banks’ interest income.
The YEA is calculated by dividing interest income on earning assets by the average value of these assets during the same period. Because some investment securities are tax-exempt, the interest income side of the ratio usually is calculated on a tax-equivalent basis to account for the added value of nontaxable income. (This is done by subtracting the tax rate from 1.0, then dividing nontaxable income by that figure.)
Because it reflects general interest-rate levels, the YEA can fluctuate considerably over time. If a bank’s YEA is high relative to those of other banks, it may indicate a high-risk portfolio of earning assets, particularly high-risk loans. If it is substantially lower than those of other banks, it may indicate that the bank’s portfolio has several “problem loans” that are yielding less than they should. Alternatively, it may simply show that the bank has overly conservative lending policies.
According to the FDIC, the average
- Cost of funding earning assets (COF). The “raw material” that banks use to produce income is earning assets, and the cost of obtaining such deposits and other borrowed money significantly affects bank profits. COF is calculated by dividing the total interest expense on the funds a bank uses to support earning assets by the total average level of funds employed in that way.
COF varies with the general level of interest rates and is affected by the make-up of the bank’s liabilities. The greater the proportion of a bank’s non–interest-bearing demand accounts, low interest-rate savings accounts, and equity, the lower its COF will be. Consequently, retail-oriented banks that derive a higher proportion of their funds from consumer deposit accounts tend to have lower COFs than wholesale banks that purchase most of their funds in the form of federal fund borrowings, certificates of deposit that have higher interest rates, and debt issuances.
According to the FDIC, the average
- Net interest margin (NIM). The NIM is calculated by dividing the tax-equivalent net interest income by average earning assets. (Tax-equivalent net interest income is calculated by subtracting interest expense from tax-equivalent interest income.)
A NIM of less than 3% is generally considered low; more than 5% is very high. This range is only a rough guideline, however, because the NIM can vary with the particular business mix of individual banks. The NIM tends to be higher at small retail banks, credit card banks, and consumer lenders than at large wholesale banks, international banks, and mortgage lenders.
A widening NIM is a sign of successful management of assets and liabilities, while a narrowing NIM indicates a profit squeeze. According to the FDIC, the industry’s average NIM was 3.29% in 2007, down slightly from 3.31% in 2006, but down more sharply from 3.49% in 2005.
- Provision for loan losses. The provision for loan losses should be considered along with the NIM when evaluating the quality of a bank’s financial performance. The provision, which appears on the income statement, is a quarterly charge taken against earnings; the charge then goes into a cumulative reserve to cover possible loan losses. (The loss reserve is a balance sheet item that is discussed later in this section under the heading “Measures of financial condition.”)
The provision’s size as a percentage of total loans reflects the success or failure of the bank’s credit evaluation procedures and the risk inherent in the bank’s loan portfolio. Over the short term, risky, high-interest loans may boost a bank’s YEA and, hence, its NIM. However, when a bank makes a greater number of high-risk loans, it needs to increase its provision for loan losses in the long term.
For any given bank, the provision for loan losses rises over time to reflect growing loan portfolios and increases in the dollar level of charge-offs; however, the provision for loan losses can vary greatly from quarter to quarter and from year to year. In recessionary times, when corporate clients find it hard to service their debts, bank managers usually raise the provision for loan losses; they generally keep it at high levels until well after an economic recovery has begun.
Although Financial Accounting Standards (FAS 5, “Accounting for Contingencies,” and FAS 114, “Accounting by Creditors for Impairment of a Loan”) govern loan loss provisioning, a bank’s managers can exercise some discretion in establishing the provision for loan losses. Hence, this provision should be examined in conjunction with the bank’s reserve for loan losses, charge-off experience, and level of nonperforming loans, to see whether management is making adequate provisions or is simply using the charge to manipulate reported earnings. According to the FDIC, provisions for loan losses for commercial banks totaled $68.2 billion in 2007, up sharply from $29.5 billion in 2006, reflecting deteriorating credit conditions.
- Noninterest income. Noninterest income includes service charges on deposit accounts, along with trust, mortgage banking, insurance commissions, and other fees. In addition, gains or losses from securities transactions, once reported separately, have been included under noninterest income since 1982.
The proportion of noninterest income to total income has risen for a number of banks. For most banks, noninterest income now constitutes more than 30% of total revenues (total interest income plus noninterest income). In 2007, the industry ratio was 39.8%, down from 42.1% a year earlier. In general, large banks tend to have a greater proportion of their total income attributable to non–interest-bearing sources than do smaller banks. This reflects large banks’ involvement in currency and bond trading, trust services, mortgage banking, capital markets activities, corporate finance, credit cards, and other fee-based financial services.
- Noninterest expenses and the efficiency ratio. Noninterest expenses represent all expenses incurred in operations, including such items as personnel and occupancy costs. To calculate the efficiency ratio, add back foreclosure and repossession expenses, amortization of intangibles, and impairment of goodwill to noninterest expenses; then divide that figure by total revenues (calculated by adding tax equivalent net interest income and noninterest income). A rough approximation can be achieved by dividing noninterest expenses by total revenues; however, it would be prudent to check the expenses that normally are added back to ensure that they are not unusually large in the period being evaluated. A high or rising efficiency ratio can signal inefficient operations, or it might reflect heavy technology spending or restructuring charges. The typical range is 55% to 65%.
The industry’s efficiency ratios worsened in 2007, to 59.4%, from 56.8% in 2006, and 57.2% in 2005, despite cost-cutting efforts enacted at most banks. Size and scale play a major role in efficiency ratios; in 2007, small banks (those with less than $100 million in assets) had a relatively high average efficiency ratio of 76.0%. Medium-sized banks (assets ranging from $100 million to $1 billion) had average efficiency ratios of 66.1%, bigger banks (assets of $1 billion to $10 billion) had average efficiency ratios of 57.6%, and the largest banks (assets greater than $10 billion) had efficiency ratios averaging 58.4%.
In general, banks that gather many of their funds from retail customers tend to have higher ratios of noninterest expenses to income than do those that purchase most of their funds. This reflects the costs involved in maintaining branches and servicing retail accounts.
MEASURES OF FINANCIAL CONDITION
- Reserve for loan losses. To protect banks from possible default by loan customers at some point in the future, they are required to maintain a reserve for loan losses. This reserve appears on a bank’s balance sheet as a contra account, or a net reduction, to loans outstanding. It is a set-aside that is built by the provision for loan losses (discussed earlier) and reduced by net charge-offs (discussed later in this section). The reserve reflects management’s judgment regarding the quality of its loan portfolio. For the outside analyst, the value of this measure is that it provides a way to judge the quality of the loan portfolio and whether the bank’s officers are adequately managing it. According to the FDIC, total industry reserves amounted to 1.29% of total loans and leases at
The adequacy of a bank’s reserve for loan losses should be judged in relation to the value of its problem loans and net charge-offs. Ratios at the higher end of the range usually indicate that a bank has a very high level of problem loans, such as nonperforming commercial real estate. However, if a bank has a reserve considerably lower than banks of similar size with comparable loan portfolios, it may indicate a lack of management prudence or a reluctance to reduce reported earnings — which, in turn, could signal another whole set of potential problems.
Over time (and assuming that the volume of loans outstanding remains steady), the provision for loan losses, which appears in the income statement, must at least equal the level of net charge-offs in order to maintain the reserve for loan losses at a given proportion of total loans. If the provision for loan losses does not rise to compensate for higher net charge-offs, management may be manipulating reported earnings by running down the reserve, or the credit quality of the company’s loan portfolio may be improving.
According to the FDIC, as of
- Net charge-offs. Net charge-offs consist of gross charge-offs netted against recoveries. Gross charge-offs represent impairments in the value of loans and leases deemed uncollectible by management. Recoveries represent the value of amounts collected in excess of the carrying value on previously impaired loans and leases.
Net charge-offs are usually measured as a percentage of average loans outstanding during a given period. For banks, net charge-offs typically range between 0.1% and 1.0% of total loans. A high percentage of net charge-offs implies that a bank has a risky loan portfolio.
Net charge-offs usually rise during a recession and decline only after an economic recovery is well under way. From a high of 1.27% in 1992, net charge-offs fell steadily until 1995, when they reached 0.49% of average loans and leases. From 1996 to 2002, a period that included a brief recession, net charge-offs climbed, reaching 0.97% in 2002, according to the FDIC. In 2003, net charge-offs began declining again, from 0.78% in that year to 0.38% of average loans and leases in 2006. In 2007, there was an increase in the level of net charge-offs, to 0.59% of average loans and leases.
· Nonperforming loans. Loans on which income is no longer being accrued and repayment has been rescheduled are considered nonperforming. The level of nonperforming loans is another indication of the quality of a bank’s portfolio. The ratio of nonperforming loans to total loans can range upward from 0.20%. When the ratio exceeds 3.00% — as it has in past years, for banks with heavy commercial real estate exposure — it can cause concern. In addition to reducing the flow of interest income, nonperforming loans represent potential charge-offs if their quality deteriorates further.
As the level of nonperforming loans rises, charge-offs and the provision for loan losses frequently rise as well. For a bank with a very high level of nonperforming loans — approaching 7.00% or more — its future may be in doubt. According to the FDIC, the industry’s level of nonperforming loans stood at 1.39% at December 31, 2007, up from 0.78% a year earlier. At June 30, 2006, the level of nonperforming loans stood at 0.70% — the lowest level recorded in the 24 years that this data has been collected.
· Capital levels. The Federal Reserve System has established two basic measures of capital adequacy with which bank holding companies must comply: a risk-based measure and a leverage measure.
Risk-based standards consider differences in the risk profiles among banks to account for off–balance-sheet exposure and to encourage banks to hold liquid assets. Assets and off–balance-sheet items are assigned to broad risk categories, each representing various weightings. Capital ratios represent capital as a percentage of total risk-weighted assets. The minimum guideline for the ratio of total capital to risk-weighted assets is 8.0%. At least half of total capital must consist of Tier 1 capital: common equity and certain preferred stock, less goodwill and other intangible assets.
The Fed’s minimum leverage ratio guidelines for bank holding companies provide for a 3.0% minimum ratio of Tier 1 capital to average assets, less goodwill and certain intangible assets. Bank holding companies making acquisitions are expected to maintain capital positions substantially above the minimum supervisory level.
To meet the regulatory requirement to be classified as “well capitalized,” the financial institution must have a leverage capital ratio exceeding 5%, a Tier 1 risk-based capital ratio exceeding 6%, and a total risk-based capital ratio exceeding 10%.
In general, the higher the percentage given for either of these measures, the more conservative the bank. A high capital ratio also indicates the ability to grow through either internal means or acquisitions. Failure to meet capital guidelines could subject a bank to a variety of enforcement actions, including the termination of deposit insurance by the FDIC and restrictions on the bank’s business by the FDIC or the Federal Reserve.
A bank that falls shy of minimum capital requirements is considered by the FDIC to be a “problem” institution. As of December 31, 2007, the FDIC’s problem-bank list had 76 institutions, with a total of $22 billion in assets, out of a total of 8,533 commercial and savings banks. This is up from the low of 47, at September 30, 2006, but well below the high of 136 in 2002. In 2007, three FDIC-insured banks failed; these were the first failures since June 2004, breaking a nearly three-year stretch in which no FDIC-insured institutions failed.
· Debt leverage. Banks incur debt when they invest in productive capacity — whether expanding their facilities or borrowing money to make additional loans for which they do not have sufficient deposits.
The extent of a bank’s financial leverage says something about its relative risk profile. One measure of leverage is long-term debt divided by the sum of equity and total debt. For banks, a figure of 45% is generally the upper limit. Banks with lower debt levels have more room to borrow should the need arise.
· Liquidity. A low debt level contributes to a bank’s liquidity (its ability to raise funds for lending and other purposes). One gauge of liquidity is the proportion of loans outstanding to total assets. A bank that is “loaned up” has a high ratio of loans to assets; 65% or more is considered high, or illiquid. In contrast, a liquid bank has a smaller proportion of its assets in loans, and more in short-term money market investments and investment securities, both of which can be quickly converted into funds and loaned out.
· Derivatives. Derivatives are financial instruments, designed to transfer risk between parties, with values derived from the level of an underlying instrument, index, or interest rate level, which can include equity or debt securities, currencies, interest rates, commodities, and even things as abstract as whether or not a company defaults on its debt. Some derivative contracts are traded on exchanges; other derivative contracts can be directly negotiated between parties, and still others can be arranged through a third party.
Banks generally use derivatives to hedge a variety of risks, including interest rate changes. As a result of such hedging, many banks have become less interest rate–sensitive.
One type of derivative commonly used by banks is an interest rate swap. A bank that receives a fixed interest rate for a particular asset may want to protect against future rate changes, since a majority of a bank’s funding is derived from floating rate sources. As a result, the bank will want to convert this fixed interest rate into a floating rate. The bank will find a party that may prefer to receive a fixed rate instead of a floating rate over time and enter into a swap agreement. The counter party may be an investor holding a floating-rate debt instrument. Such an investor may decide to convert the current floating rate into a fixed rate, thus locking in future interest payments related to that investment. As a result, the bank would receive payments that change as interest rates change from the counter party and make payments to the counter party at the agreed upon fixed rate. Of course, only the net difference between the payments would change hands between the parties.
Derivatives pose inherent risks if they are not used for hedging purposes, as there is the chance that the bet will not go in the direction that one hopes. Most derivatives contain counter-party credit risk, in which a counter party may fail to fulfill an obligation specified by the derivative contract terms.
Credit exposure is assessed by the cost to replace a contract at current market rates. Many banks try to limit counter-party credit risk in one or more ways. They can deal with derivatives dealers that are national market makers with strong credit ratings in their derivatives activities. They can subject counter parties to credit reviews and approvals similar to those used in making loans and other extensions of credit. Finally, they can require counter parties to provide cash collateral when their unsecured loss positions exceed certain negotiated limits.
